Passive Interest

The current focus on 401(k) fees has led more plan sponsors to move toward the use of passive investment options. But few have opted to add exchange-traded funds (ETFs) so far.

Defined contribution (DC) plan sponsors who changed their active/passive mix of funds last year increased their plans’ use of passive funds by 44.8%, according to consultant Callan Associates Inc.’s 2012 Defined Contribution Trends Survey, which featured many large plans. And yet, Callan pegged the percentage of 401(k) plans using ETFs at just 2.5% in 2011. PLANSPONSOR’s 2011 DC Survey finds even fewer; across all plan sizes, only 1% of plan sponsors say they use ETFs as an investment vehicle in their plans.

There has been considerable 401(k) sponsor interest in passive management lately, agrees Sue Walton, a Chicago-based director at consultant Towers Watson. “Part of it is having a good understanding of the purpose they are trying to serve on the target-date side,” she says. “Those investors are typically less engaged; so to be able to offer market exposure—as long as the diversification is there—in a lower-cost, less-volatile space has been the driving force.” Most plans transitioning to indexing on the target-date side have assets of more than $1 billion, she says. More-engaged participants making their own investment decisions want passive options, too, she says, and sponsors typically add institutional commingled trusts to meet that need. Sponsors prefer the trust option because of the very low cost and the lack of securities lending, she says.

But ETFs continue to have a greater appeal to retail investors than to plan sponsors—for several reasons. First, the cost advantage they offer retail investors applies less to 401(k) plans. Larger sponsors usually turn to collective trusts and separate accounts for passive investing, says Lori Lucas, Callan’s defined contribution practice leader. “ETFs are probably not as appealing, because sponsors can get a pretty cost-effective investment when they look to these other investment structures,” she says.

Moreover, large plans adding indexing to their options have access to institutional mutual funds for reasonable fees, whereas the small ones do not, says Toni Brown, San Francisco-based director of U.S. client consulting at Mercer. She works mostly with plans that have $100 million and more in assets. The largest plans adding indexing often move to collective trusts, she says, because of the lower fees. “If you are talking about a plan sponsor with a larger defined benefit plan as well as a 401(k), they can really drive down the fees, to as little as a basis point for the S&P 500,” she says.